Faulty Documents May Cause Losses

Some credit unions are originating business loans with documentation deficiencies that could result in unenforceable promissory notes and collateral documents.

If notes and collateral documents are deemed unenforceable and the credit union does not take steps to correct the situation, losses could result. For credit unions using automated loan documentation programs that produce flawed notes or collateral documents, small dollar business loans could multiply into potentially large losses.

A common cause of inappropriate documentation begins with the misinterpretation of business loan regulations that state business loans of less than or equal to $50,000 and business loans fully secured by a one-to-four family dwelling are not considered member business loans.

Institutions confuse the statutory MBL exemptions noted above with the legal context of business lending. It is extremely important that all institutions realize that a business-purpose loan (generally defined in the commercial banking sector as a loan where 51% of the proceeds of the loan are for a commercial or business purpose) must meet all contractual legal documentation requirements regardless of size or collateral.

Inadequate business loan documentation can come in many forms. The most common are improper signatures on promissory notes and collateral documents made to entities and lack of proper attachment and perfection of collateral due to either signature or ownership.

These deficiencies arise due to lack of knowledge or attempting to utilize automated loan products, which are generally designed for consumer loans, which do not have proper commercial loan documentation capabilities.

Who is the borrower?

If an entity (other than an individual) is the borrower or co-maker/borrower, the institution must have documentation of who is authorized on behalf of the entity to borrow (borrowing resolution) and the note must reflect the proper signature of the authorized borrower.

For entities, a typical promissory note signature block would be:

Borrower: XYZ Inc.

Signature block: XYZ Inc.

by: __________________

John Smith, President

What we see, especially in institutions using consumer loan products to originate business loans, is:

Borrower: XYZ Inc.

Signature block: [signed by an individual]

This is not a proper signature block for a business loan to an entity. The question could arise: Do we have an enforceable loan to XYZ Inc.?

Who owns and pledges collateral?

For some business loans, the real or personal property used to secure the borrowing transaction (pledged as collateral) may be owned by an individual or an entity, other than the borrowing entity, who pledges the collateral on behalf of the borrower.

In such cases, collateral documentation must reflect the proper ownership and pledge of property to the borrower. Common methods of attaching property owned by someone other than the borrower are referred to as third-party pledges, hypothecation agreements or grantor.

Security or collateral documentation must include a method of attachment of the property to the borrowing transaction. Perfecting the security interest or collateral must then be accomplished.

Again, as with the promissory note, care must be taken to have the proper signature of the owner of the real property or personal property.

For entities, a typical signature block for the owner or grantor (owned by an entity other than the borrower) of collateral would be:

Borrower: XYZ Inc.

Grantor: ABC Inc.

Signature block: ABC Inc.

by: _________________

[Authorized owner (grantor) of the property]

We see, especially in institutions using consumer loan products to originate business loans, the security agreement or deed of trust or mortgage being signed:

Borrower: XYZ Inc.

Signature block: [signed by an individual]

This is not a proper signature block. The question could arise: Do we have an enforceable pledge of collateral?

For a business loan transaction where the individual owns the collateral and signs the collateral document, care must be taken to ensure the pledge of the collateral to the borrowing transaction has occurred via a third-party pledge, hypothecation or grantor language.